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Busting the supermarket myths

Sophie Lund Yates, Equity Analyst, explores what coronavirus currently means for supermarkets, and why it’s not necessarily the good news you might expect.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please
seek advice. If you choose to invest the value of your investment will rise and fall, so you could get
back less than you put in.

Sophie Lund-Yates, Equity Analyst

14 May 2020

We’ve had a look at the way coronavirus is changing the retail industry, and we talked about how the recent stockpiling could actually be painful for supermarkets.

But we wanted to take a closer look at why this is, as well as what’s going on with the UK’s grocers. It’s important to bust the myth that the current situation is an out and out tailwind for the sector.

This article isn’t personal advice. If you're not sure what’s right for your circumstances, please seek advice. All investments and their income fall as well as rise in value, so you could get back less than you invest. Past performance is not a guide to the future.

Myth 1 – a surge in demand is great news

Hiring new staff, covering staff sick pay, sourcing and distributing more products and increased hygiene procedures are just some of the extra costs supermarkets have to consider at the moment.

To put the extent of these costs into context, Tesco has said despite the huge uplift in sales in recent weeks, full year profits won’t be positively affected. That comes as costs are expected to rise by up to £925m, and also assumes shopping habits return to normal by the end of summer. Fellow grocer Sainsbury expects full year profits to be affected by £500m of extra costs too.

This helps explain why Sainsbury, along with Morrison, has put dividends on hold for now.

But rising costs are just one, fairly intuitive, outcome of the disruption. The other thing to keep in mind is changing spending habits.

Where we’ve been pushed down the food aisles, general merchandise sales aren’t faring so well. If you think about today’s superstores you’ll remember a significant chunk of floor space is given over to things like homewares, books and electrical items.

This is a particular bugbear for Argos owner Sainsbury. It’s more exposed if non-food products fall out of fashion. In all the group expects continued significant double digit percentage sales declines for General Merchandise for the remainder of the first half.

Percentage of sales

Source: Sainsbury 2020 final results, accessed 5 May 2020

We’re mindful that spending habits won’t go back to normal once lockdowns are lifted. A recession is likely, and a jittery economic outlook manifests in a nervous customer base. The latest research from the ONS suggests anxiety has spiked in the UK population, particularly among those who feel like they’re unable to save any money at the moment.

As discretionary spending comes under pressure, we’ll keep buying food but we’re more likely to hold off upgrading the toaster. Most of the grocers are exposed to general merchandise to some extent, but this will impact the revenue, margins and profits of some more than others.

Myth 2 – a pandemic evens the playing field

You’d be forgiven for thinking panic buying irons out the normal competitive pressures faced by the grocers.

Sadly this isn’t true, and in many ways coronavirus is highlighting pre-existing pressure points. The first thing to consider is why Tesco initially saw sales volumes balloon well above its rivals. We think this could have a lot to do with the group’s superior own-brand offerings.

Aldi and Lidl have encroached on supermarkets’ market share in recent years, suggesting consumers are more willing to buy an unbranded product these days. And this is where we think Tesco has the best of both worlds – its stores are much bigger than the German discounters, which means it now offers the double threat of an extensive range, as well as shelves stacked with own-label.

The big question for Tesco is how it will propel growth once things start to get back to normal. Both margins and sales have come a long way, so the challenge for incoming CEO Ken Murphy is how to get more juice from what is now a well-squeezed lemon.

We can’t knock Tesco’s dominant position – it currently commands almost 27% of the UK grocery market – or the progress made. But some investors might want to consider supermarkets with more immediate growth opportunities. Morrison’s sales growth has been trailing its rivals’ recently. We’d argue this could be an opportunity for future growth, particularly in conjunction with the fledgling wholesale business – it’s on track to generate £1bn in revenue in the not too distant future.

UK Grocery Market Share

Source: Kantar data, as at 19 April 2020. Accessed 5 May 2020

Morrison traditionally has a fairly healthy free cash flow too, with £238m generated last year. The balance sheet’s also in decent nick, helped by the fact it owns rather than leases most of its stores. That’s also helped it pay special dividends in the past. The sturdier financial position could make it a safer pair of hands than one that carries more lease-related debt, though there are no guarantees.

The supermarket landscape was competitive before the outbreak, and that hasn’t changed. We’d encourage investors to remember to look beyond short-term noise and really understand what makes individual companies tick. A pandemic does not mean all supermarkets are created equal.

Myth 3 – the only way is up for online shopping

Demand is far outstripping supply for online delivery slots. We also think the disruption will have accelerated the shift to online shopping, as more households become accustomed to the service.

But this shift hasn’t upended the industry overnight. Tesco said between 85% – 90% of all food purchases still involve a visit to a shop, despite recent efforts to ramp up supply of online deliveries. It’s reasonable to assume this will be good news for online sales for the big four. But it would be a mistake to think the whole sector has suddenly moved online.

We also wonder how far Morrison’s participation will go. It has a much smaller digital footprint than its rivals, so we might see a big acceleration in its capacity. But it could also mean it’s too small to fully benefit from the increase in demand.

Online grocer Ocado hit the news after it stopped accepting orders having been inundated with requests. But we think people need to remember this recent performance alone doesn’t really change the investment case.

Not only has half the UK retail business been sold to Marks & Spencer, but Ocado’s future relies more heavily on its Solutions business. This is where it charges other retailers to use its robotic warehouses. A more general shift to online shopping would be good news for the division as international grocers look to boost their digital offering. However, we also wonder if a severe economic downturn could have a negative effect. Depending on the extent of any damage on Ocado’s potential customers, some retail chains could be less willing to spend heavily on expansion.

It's also worth remembering Ocado remains heavily loss making. And that also makes it harder to value than a more traditional company. Looking on a purely sales basis, the shares trade on a much higher valuation than its average. That means there are high hopes for the future, but the share price could fall sharply if growth disappoints.

The picture is a little clearer for M&S. It relies heavily on travel traffic and city centre footfall (think service stations and office lunch breaks). As a result M&S’ food business hasn’t experienced the same uplift as the bigger supermarkets.

But with its products set to be available on Ocado in September, compared to its largely non-existent online footprint today, we suspect this will be good news for sales. And by owning 50% of Ocado’s UK retail operation, it stands to gain from any benefits too. The recent disruption has probably enticed a meaningful number of longer-term Ocado customers. And we suspect the switch from Waitrose to Marks & Spencer items won’t be a reason to hang up their membership.

Investors should be careful not to assume that the industry is suddenly going to be a digital-only space. This is a catalyst for longer-term change, but in our view the online disruption hasn’t really altered the investment case for any of the big names.

So should investors give up on supermarkets altogether?

Not necessarily - supermarkets are essential for keeping the UK fed. That makes them a more defensive option than some other businesses. But this should serve as a reminder of how important it is to know individual companies within a sector, even if things look good on the surface.

Valuation also remains an important factor to consider, especially as we think it’s a mistake to assume the pandemic’s a net benefit for the industry.

Hargreaves Lansdown's Non-Executive Chair is also a Non-Executive Director of Tesco.

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Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek
advice. If you choose to invest the value of your investment will rise and fall, so you could get back
less than you put in.

While the causes have been different, we've seen markets move like this before. We take a look at what's happened in the past.

Emilie Stevens, Equity Analyst

01 Jun 2020 | 6 min read

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